The Ups and Downs of the Multifamily Capital Markets

Stephen A. Sobin

With the beginning of the new year, there is still much uncertainty in the national commercial real estate market. Higher borrowing costs stalled many commercial real estate transactions in the second half of last year, and this trend is expected to continue throughout the first half of 2023. Additionally, many sellers still refuse to bring down their asking prices in line with a rising rate environment. Investors are anxiously hoping for a respite in Fed interest rate hikes this year.

Throughout 2022, the Fed raised its benchmark federal funds rate around 400 basis points to 4.33 percent to combat inflation. While rate hikes have brought inflation down from a high of 9.1 percent to around 6.5 percent, we are still a long ways away from the Fed’s desired annual inflation rate of 2 percent. Arthur Milston, a senior managing director at NAI Global, notes that the Fed will likely continue to raise rates in the first half of 2023 to bring the inflation rate down even further. These market fundamentals will likely continue to stall transactions across many sectors in the commercial real estate space.

There is some optimism, however, amongst multifamily investors. Many people are looking to rent as higher interest rates have made it more difficult for them to buy homes in this market. This market climate should continue to fuel solid demand for multifamily housing throughout the next 12 months. The previous year saw multifamily activity rise to the top above all the other sectors. Through November of 2022, the market recorded over $272 billion in multifamily transactions. The sector far outpaced the second-place industrial market by about $135 billion. Milston notes that this trend is likely to continue in 2023 as investors will look to place their money in multifamily properties.

While multifamily will likely lead the charge in 2023, the sector is still likely going to experience moderation relative to its performance in 2021 and the first half of 2022. Sellers in this sector are still hesitant to lower their asking prices to match rising cost of capital. In Q3 2022, cap rate spreads fell to 150 bps. This was the lowest spread since 2007. Experts anticipate this trend to continue in the first few months of 2023. However, at some point in 2023 experts believe that cap rates will rise and put downward pressure on property prices. According to Freddie Mac, many investors will stay put and not sell until rates come back down and more favorable investment opportunities arise. Many investors refinanced their debt at all time low rates in the past couple of years. With lower rates and strong rent growth in the recent years, these investors will be able to pay their debt and hold out on selling until the market stabilizes. Lower transaction volume will lead to a decrease in origination levels. Freddie Mac expects multifamily originations to decrease around 5 percent to $440 billion in 2023.

Financings on Hold

Experts at Freddie Mac suggest that vacancy rates will rise to 5.1 percent by the end of 2023. This would mark a 30 basis point increase from the end of 2022. Aside from 2020 when the vacancy rate rose to 5.3 percent due to COVID-19, vacancies have not been above 5 percent since 2011. Rents are expected to grow around 3.9 percent this year. While this rate sits at the lower end of the rent growth spectrum for the last decade, it is still considered as healthy returns in the market.  Another potential pain point in the multifamily market this year is in the value-add sector. Due to higher interest rates, many value-add investors on variable rate debt terms will likely have a hard time refinancing when their short term loans mature. Those investors who choose to sell may have a hard time generating their expected returns due to declining property values. Additionally, the SOFR rate, which serves as one of the benchmark rates for value- add deals, has increased over 400 basis points since the beginning of 2022. These pain points have led many lenders to put a hold on financing value-add transactions until the market calms down.

There are many reasons for multifamily investors to be both optimistic and cautious in the upcoming year. The next few months will likely be pivotal in determining the sector’s trajectory for the next 12 months. As inflation hopefully settles, the second half of the year will likely be much more robust for the sector than the first half of 2023. There are multifamily deals to be had in this market. Prudent investors will find the right deals and discard the ones that simply do not work.

Stephen A. Sobin is the president and founder of Select Commercial Funding LLC, a nationwide commercial mortgage brokerage company. He is a proud member of the InterCapital Group, a nationwide alliance of commercial mortgage professionals.